Finding the Right Policies for Mexico's Economic Crisis Depends on Finding the Right Explanations
The economic crisis that erupted in Mexico in December 1994 has been scrutinized and written about at great length by policymakers, business and academic economists, and the press. Many academic economists have tried to explain what went wrong with Mexico's economy and have made recommendations for future policy approaches based on particular explanations of the underlying problem.
Two articles in the Federal Reserve Bank of Atlanta Economic Review show how different explanations influence the interpretation of Mexico's economic crisis and in turn lead to different policy prescriptions. In one article, Atlanta Fed economist Joseph A. Whitt Jr. looks at the crisis from a conventional perspective. Whitt discusses the peso devaluation as the inevitable result of fiscal, monetary, and exchange rate policy imbalances in the Mexican economy that might have been corrected by earlier adjustments in macroeconomic policy.
In the second article, Marco Espinosa, an Atlanta Fed senior economist, and Steven Russell, an assistant economics professor at Indiana University-Purdue University at Indianapolis (IUPUI), critique this conventional view of the crisis. Their analysis casts doubts on its validity. Their alternative view emphasizes deepening investor concerns about the safety of Mexican financial obligations combined with the short-term nature of the bulk of Mexican debt.
Both articles chronicle the historical events that led to the crisis. In the early 1990s the Mexican economy seemed healthy, growing again after experiencing severe problems in the 1980s. With the implementation of the North American Free Trade Agreement at the beginning of 1994, they note, Mexico's rise above hard times seemed secure. Less than a year later, though, the country faced economic disaster as devaluation of the peso in December spawned a financial crisis that cut the peso's value in half, stimulated inflation, and set off a severe recession.
Hoping to avoid an economic slowdown during 1994, Mexico had tried to maintain its quasi-pegged exchange rate while limiting monetary tightening by accumulating international reserves and reducing domestic credit--a policy that is not sustainable for long. The ultimate result was a collapse of the exchange rate, soaring interest rates, and probably a far worse recession than would have occurred if monetary policy had been tightened.
Whitt asks whether Mexican policy mistakes made devaluation of the peso inevitable. He focuses on Mexico's policy actions during 1994--as well as options Mexico did not take. He also reviews market response to the devaluation and Mexican and U.S. government efforts to cope with its aftermath. In his view, this episode highlights the severe constraints on monetary policy that arise if a government wants to maintain a fixed or quasi-pegged exchange rate.
The ensuing crisis continues to have severe consequences for the Mexican economy. Nevertheless, Whitt sees hope that the combination of a relatively sound budget position, more effective Mexican policies, and the assistance arranged by the United States and the International Monetary Fund will enable Mexico to recover much more quickly from this crisis than it did after its 1982 crash.
Espinosa and Russell, espousing an alternative view, suggest that many of the explanations for the 1994 crisis are based on questionable assumptions and dubious analysis that concentrates on the wrong economic "fundamentals." They challenge the conventional view that the crisis was caused by a combination of flawed fiscal, monetary, and exchange rate policies. Their explanation emphasizes the vulnerability of the Mexican financial system to swings in expectations and investor confidence.
In Espinosa and Russell's view, the Mexican financial crisis was an expectations-driven liquidity crisis similar to the financial panics that afflicted the U.S. economy during the late nineteenth century. The immediate cause of the Mexican crisis was political turmoil that created concern among foreign lenders about the safety of their investments. Mexican borrowers' heavy reliance on short-term liabilities made both individual borrowers and the financial system extremely vulnerable to the diminished confidence of foreign investors.
Espinosa and Russell's principal policy recommendation is for the Mexican government to set up a system of term-graduated multiple reserve requirements to act as "circuit breakers" for banks. These requirements would give financial institutions (and direct borrowers) strong incentives to lengthen the average term of their debts and make the country's financial system less susceptible to liquidity crises. The average term of the government's liability portfolio would also increase, reducing its own vulnerability to liquidity crises.
Economic Review Abstracts